Ask Colin

My liquidity rule is that the 45-day average of volume times price must be more than 10% of my trading capital. Is this adequate?

I don't like using averages at the best of times. You will know about the man who drowned in a lake with an average depth of 10 centimetres. Also about the man with one hand in a fire and the other hand in a block of ice, that was just the right temperature on average.

My own liquidity rules also take account of the percentage of capital that is to be put into a trade, as set out in the videotape of my seminar.

My own liquidity rules also allow some flexibility in that I am prepared to have one or two (no more) trades at any one time that are not very liquid.

My liquidity rules basically are:

  • The stock must trade on most days.
  • When it trades, it should usually be in enough volume for me to get in, and especially out, in one bid or offer.

What worries me about your rule is that you said (not repeated in the question) that you will take positions up to 12% of capital. This means that on the average day, your 10% rule will mean that you will have to buy or sell the entire average day's business and still have to complete the order next day. I don't think that I would want to be in this position very often, and then only on one or two trades at a time, as I say. However, as I also said earlier, averages can hide a lot. I prefer to look at the distribution of the volume. There may be plenty of liquid days with no trade days in between that bring the average down. What is more important to me than average volume is whether there is enough volume near the bid or offer for me to trade "at market". Thus, my order will usually be only a small part of the volume on most days.

However, don't take any of these rules, mine or anyone else's, as absolute. Liquidity is only one of many types of risk that must be managed in a trading plan (see the videotape of my seminar). They can rarely be taken in isolation. So, my liquidity rules are set in relation to the risks I am taking in other areas of the trade. Your liquidity rule is more aggressive than mine. However, other parts of your trading plan may be more conservative (not position size though, if you go to 12% of capital). Or you may simply be prepared to tolerate more risk overall than I am.

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